Consumer Price Index (YoY) (MAY) (12:30 GMT; 08:30 EST)
Expected: 2.6%
Previous: 2.6%

CPI Core (YoY) (MAY) (12:30 GMT; 08:30 EST)
Expected: 2.3%
Previous: 2.3%

How Will The Markets React?

The release of the US consumer price index on Friday will establish if the huge sell-off of Treasuries and the US dollar rally is over – at least for the short-term. Inflation is, by and large, the primary determinant of Federal Reserve policy, and despite the Fed Chairman Ben Bernanke’s consistently hawkish stance, we’ve been started to see mixed signals. The producer price index highlighted a greater-than-expected gain during the month of May, however, import prices softened while the Federal Reserve’s Beige Book for the same period indicated that most areas did not see a pick up in "overall price pressures" while "wage pressures do not seem to have increased.” As a result, traders will be even more anxious to see the actual results of CPI, and this could lead to a large spike in price action. If the economic indicators, particularly the core measure, unexpectedly rise, bond, FX, and equity markets alike will move ahead to price in a potential rate hike by the Fed this year. On the other hand, a sharp slowdown in CPI towards the central bank’s 1-2 percent target would bring back the notion that the Fed will stay on hold throughout the year – if not cut rates. The one major caveat is: what if the figures hit the tape in line with expectations with the annual rates unchanged? Such a result would likely lead to a spike in volatility as well, but would fail to initiate a large shift in directionality.

Bonds – US 10-Year Treasury Note Futures

Price action on Treasury futures were muted on Thursday, though they managed to hold above the previous session’s low of 103.20. With the sell-off in bonds a bit overextended, it appears likely that the bounce will continue up to a region of fibonacci resistance near 104.25/30. Such a move would only be exacerbated by the release of CPI in line with or softer than expectations, as the data would not underpin the case for an increasingly hawkish bias by the Federal Reserve. On the other hand, a surprise pick up in inflation pressures would turn Treasuries on a dime and send futures back to the recent lows of 103.20.

FX – EUR/USD

Trading of EUR/USD has grinded to a halt ahead of the all-important US CPI release, as traders are anxious to gauge the Federal Reserve’s next move. Over the past week, EUR/USD has fallen sharply amidst hawkish commentary from FOMC members and the steep ascent of Treasury yields. However, now that the pair has broken through the 100 day SMA, EUR/USD has met formidable support at the 50.0% fib of 1.2866 – 1.3684 at 1.3277, and whether it can push down through this level or will bounce higher may be broadly determined by the result of the CPI report. A very strong inflation report would reignite speculation of policy tightening by the Fed and could take EUR/USD down to break 1.3300 to target support at 1.3220. On the other hand, a very soft release that cools expectations for Fed hikes could propel the pair up towards 1.3380. However, CPI in line with expectations, which happens to be the more probable scenario, could bring about a spike in volatility, but subsequently leave EUR/USD to meander around 1.3300 until next week, as price action will become more reliant on Euro-zone data.

Equities – S&P 500 Index

US equities gained today, as energy shares rallied to a record on a surge in oil prices and led the S&P 500 Index up 0.5 percent to 1522.97 in New York. An index of energy shares rose 1.9 percent to a record and contributed the most among 10 industries to the S&P 500's advance after crude oil for July delivery rose $1.39 to $67.65 a barrel in New York, with Chevron gaining $1.18 to close at $82.33. Meanwhile, AT&T added 58 cents to $40.56 as the biggest US phone company may gain as many as 915,000 customers in the second half of this year as the sole wireless service provider of Apple Inc.'s new iPhone.

The fate of the S&P 500 tomorrow will depend on the release of US CPI. The benchmark equity index is targeting the recent highs at 1,540.00, but indications that inflation is picking up could drive the S&P down towards Fibonacci support at 1,490, as the data would lead the market to ramp up speculation of a rate hike by the Federal Reserve. On the other hand, if headline and core CPI hold steady on an annual basis or contract towards the Fed’s 2.0 percent ceiling, equities could actually see a decent boost towards the highs since the central bank’s hawkish bias would not be supported. Regardless, any CPI result that misses expectations will lead to a surge in intraday volatility.

Terri Belkas is a Currency Analyst for FXCM.